Forward contract vs Future contract. Forward and futures contracts are derivatives arrangements that involve two parties who agree to buy or sell a specific asset at a set price by a certain date in the future.
Buyers and sellers can mitigate the risks associated with price movements down the road by locking in the purchase/sale price in advance.
Key Difference between forward contract and futures contract
Forward contracts are traded on personal basis while future contracts are traded in a competitive arena.
Forward contracts are traded over the counter whereas futures are exchange-traded.
Forward contracts settlement takes place on the date agreed upon between the parties whereas futures contracts settlements are made daily.
Cost of forward contracts is based on bid- ask spread whereas futures contract have brokerage fees for buy and sell order.
In case of forwards, they are not subject to marking to market. On the other hand, futures are marked to market.
Margins are not required in the case of a forward market whereas in futures margin is required
In a forward contract, credit risk is borne by each party whereas in the case of futures the transaction is a 2-way transaction, hence both parties need not bother about the risk
Definition of Forward Contract
A forward contract is a private agreement between the buyer and seller to exchange the underlying asset for cash at a particular date in the future and at a certain price.
On the settlement date, the contract is settled by physical delivery of asset in consideration for cash.
The settlement date, quality, quantity, rate and the asset are fixed in the forward contract. Such contracts are traded in a decentralized market, i.e. Over the counter (OTC) where the terms of the contract can be customized as per the needs of the parties concerned.
The buyer in a forward contract is considered as long, and his position is assumed as a long position while the seller is called short, holds a short position.
When the price of the underlying asset rises and is more than the agreed price, the buyer makes a profit.
But if the prices fall, and is less than the contracted price the seller makes a profit.
Examples of Forward Contracts:
Assume If two parties agree to the sale of 1,000 ears of corn at $1 each (for a total of $1,000), the terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that delivery of the asset or cash settlement (if specified) will take place.
Definition of Futures Contract
A binding contract that is executed at a later date is a future contract.
It is an exchange-traded contract of a standardized nature where two parties, decide to exchange an asset, at an agreed price and future specified date for delivery and payment.
A future contract is standardized in terms of the quantity, date, and delivery of the item. The buyer holds a long position while the seller holds a short position in this contract.
As the contracts are traded in the official exchange, which acts as both mediator and facilitator between the buyer and seller.
The exchange has made it mandatory for both parties to pay an upfront cost as a margin.
Forward contract vs Futures contract
| Parameter | Forward Contract | Future Contract |
|---|---|---|
| Meaning | A Forward Contract is an agreement between parties to buy and sell the underlying asset at a specified date and agreed rate in the future. | A contract in which the parties agree to exchange the asset for cash at a fixed price and at a future specified date is known as a future contract. |
| What is it? | It is a tailor-made contract. | It is a standardized contract. |
| Traded on | Over the counter, i.e. there is no secondary market. | Organized stock exchange. |
| Settlement | On maturity date. | On a daily basis. |
| Risk | High | Low |
| Default | As they are private agreements, the chances of default are relatively high. | No such probability. |
| Size of contract | Depends on the contract terms. | Fixed |
| Collateral | Not required | The initial margin required. |
| Maturity | As per the terms of contract. | Predetermined date |
| Regulation | Self-regulated | By stock exchange |
| Liquidity | Low | High |
